Do Commission-Free ETF Trades Have a Hidden Cost?

Much ink has been spilled heralding the announcements that Schwab, Fidelity and Vanguard were eliminating commissions on exchange-traded funds (ETFs) to one degree or another. And as both I and my Moneywatch colleague Allan Roth have written, that development has the potential to be a good one for investors.

But as appealing as commission-free trades might seem to be at first glance, those trades might come with a cost that doesn't show up in any prospectus or on your quarterly statement.

When you place a trade for an ETF, that order is routed to and fulfilled by one of several "market centers," which match buyers and sellers of those securities. But not all market centers are alike. When you place an order, the SEC requires that buyers receive the best available ask price, and sellers receive the best available bid price, which is known as the national bid and best offer (NBBO). Orders fulfilled at large, liquid market centers are likely to be executed at the best price (or, perhaps, even an improved price). But orders fulfilled at smaller, less liquid centers might be executed at a price outside the NBBO.

With that in mind, Omer Uzun from the blog Fundometry recently took a look at ETF trades fulfilled by Fidelity's market center, and compared them to those fulfilled by a number of other market centers. What he found was that orders fulfilled by Fidelity were much more likely to be executed at prices outside the NBBO than orders executed by other brokers. Some 75 percent of all commission-free ETF trades executed by Fidelity in the first three months of this year, for instance, suffered from what Uzun calls "price degradation" (i.e. executed at a price outside of the NBBO). Interestingly, the ratio was even worse for trades subject to a commission at Fidelity, with roughly 80 percent subject to price degradation, which indicates that Fidelity has been a bit sloppy in executing ETF trades. Unfortunately, the lion's share of trades in Fidelity's no-commission ETF lineup was handled by Fidelity.

The cost of these poorly-executed trades was tiny on a per-share basis; mere fractions of a penny. But even those tiny amounts can add up when hundreds of shares are bought or sold frequently. As Uzun concluded:

For financial advisors or long-term investors who prefer using ETF's, the price impact may not be meaningful enough to diminish the cost savings from zero commissions, as long as trades are not too frequent. Conversely, for day traders, the economics of avoiding a commission may not offset [the] adverse price impact....

What does this mean? If you trade frequently, or even not-so-frequently but in large amounts, the amount that you lose in poor execution by a sloppy market center could easily surpass the commissions you would owe at another broker. It seems that free lunches are very hard to come by.